If you think you know how bad the mutual fund scandal is, you're wrong. It's worse.

In the summer of 2002, Brean Murray, a small, obscure brokerage house, threw a dinner party in the Hamptons. It was a dismal time for investors, two years into a brutal bear market. But the doom and gloom that permeated Wall Street was largely missing on the back lawn of the tony Southampton Club, where the 100 or so guests sipped drinks from an open bar and munched on barbecued steak and ribs while taking in the sea breezes. If they were a happy bunch, they had good reason. Several of Brean Murray's clients were in a new and enormously profitable line of business—one that the average investor knew nothing about. They were market-timing mutual funds.

Among those in attendance that July evening was a skinny 37-year-old hedge fund manager named Eddie Stern. Stern, an heir to one of New York's biggest fortunes, managed more than $500 million for both his family and outside investors. Since he launched his market-timing hedge fund, Canary Capital, in 1998, his record had been little short of astonishing. In 2000, for instance, a year in which the S&P 500 dropped 9%, Canary returned almost 50%; the following year the S&P 500 fell another 13%—while Canary gained close to 29%. Many other market timers had similar records.

There was just one problem: Under the rules in place at most mutual fund firms, market timing was forbidden. The fund industry has long acknowledged that market timers—that is, investors who rapidly trade in and out of mutual funds—hurt buy-and-hold shareholders. As a result, most fund prospectuses contained language bluntly declaring timers unwelcome.

As we now know, however, many fund companies did permit market timing—for select investors. While the average shareholder was left in the dark, a kind of alternative mutual fund universe emerged, one that included not only market-timing hedge funds but also middlemen who arranged illegal trades and secret deals, fund insiders who gave timers proprietary information, and fund companies that embraced timers to boost their own bottom line.

Indeed, market timing had become such an open secret that one attendee at the Brean Murray party was an internal regulator at Alliance Capital, one of America's 20 biggest fund firms. Although this man was one of Alliance's "timing police," his job wasn't really to stop big timers. It was to make sure they were abiding by the terms of their timing agreements with Alliance. (Alliance declined comment.)

Market timing of mutual funds is no longer a secret. Instead it has become a full-blown scandal—the biggest in the history of the $7 trillion fund business. Today virtually the entire industry is under investigation—by New York State attorney general Eliot Spitzer and other state regulators, by the Justice Department, and—belatedly—by the SEC. Many of the business's biggest names stand tarnished, including Pimco, Janus, Strong Capital, Putnam, MFS, Franklin Templeton, PBHG, and Alliance. Former executives at Bank of America, Fred Alger, and CIBC have been led away in handcuffs. And investigators say there is more to come. "Every time we turn over a rock in the mutual fund business," declares Spitzer, "we find vermin crawling beneath it."

At the center of the scandal stands Eddie Stern. It all started with him—with a call by one of his former employees tipping off Spitzer's gumshoes. Within months the billionaire's son had cut a deal to cooperate with prosecutors. Since then Stern has served as their guide into this shadowy world. "He's been incredibly valuable in cracking this open," says Spitzer deputy David Brown, who heads the AG's investigation.

Eddie Stern's saga is the untold tale of the market-timing scandal: where the practices were conceived, how they took hold, and how they metastasized from a benign cat-and-mouse game to a sophisticated gambit in which hedge funds slung around billions, compromising an entire industry. "It was like a little brotherhood of people who embraced this niche in life," says Brown, "a whole grotesque industry growing up based on screwing small investors. It's about as bad as it gets."

The Pioneer
If there is one man who showed the world—and Eddie Stern—that there was big money to be made in the rapid trading of mutual funds, it is surely Gil Blake. Trained as an accountant, the 58-year-old Blake is a soft-spoken, almost professorial man who served as an officer on a nuclear sub and then earned an MBA at Wharton before becoming CFO of a small, privately held Massachusetts company.

In 1980, Blake quit to become a mutual fund trader. Poring over old microfilm records in the public library near his home outside Boston, he developed trading strategies rooted in the historical pricing patterns of mutual funds. In his first 12 years as a fund timer, Blake averaged 40% annual returns—and never had a year when he earned less than 24%. He named his small investment company Twenty Plus.

Blake started out trading municipal bond funds, using a kind of momentum strategy. He discovered that there was a high probability that an uptick in the price of a muni bond fund would be followed by another up day. And another. Blake realized he could make easy profits by jumping into a fund when it started to go up and leaping back into cash when it started to go down. What made the approach especially attractive was that, unlike equity trading, which required paying hefty commissions, darting in and out of a mutual fund was free. For Blake it was simply a matter of spotting patterns that improved the odds—and then making rapid-fire trades. "I liken it to card counting," he says.

Blake's analogy is apt in another way. Though card counting is not illegal, card counters are nonetheless the bane of the casino industry. In theory, at least, market timers are the bane of the fund industry. Why? Because rapid trading by one very large customer can wreak havoc on the ability of the fund manager to make money for everyone else. Big sums rushing in and out rob the manager of flexibility in buying and selling stocks. He has to keep extra cash at the ready to pay the exiting timer, which dampens performance. Timing also boosts trading expenses and generates capital gains, which impose costs on the fund's shareholders. According to one academic study, timing costs long-term mutual fund shareholders as much as $4 billion a year.

Perhaps just as important, market timing is antithetical to the fund industry's image. The industry has long marketed mutual funds as stable, long-term vehicles, ideal for small investors and run by decent, honorable people like Peter Lynch, the great former Fidelity Magellan manager. Industry executives reveled in the contrast between their business and the rest of Wall Street, with its reputation for skinning small investors instead of helping them.

For these reasons, mutual fund firms often included language in their prospectuses to discourage market timing. Such language typically gave the fund the right to shut down anyone making more than a specified number of in-and-out trades (usually four) in a year. One of the companies with such language was Fidelity Investments, which has not been tainted by the current scandal.

Yet Blake says he was timing Fidelity's municipal bond funds—and some people at the company knew it. "I had occasional conversations with people at Fidelity about this," he recalls today. "They said, 'No problem, just keep a low profile. If you're going to switch, keep the amounts reasonable.' They didn't care if I made four trades or 14." (Fidelity says it cannot address issues involving individual shareholders.)

By the mid-1980s Blake was employing new timing approaches and investing for about 15 relatives, tennis partners, and poker buddies. Much like a hedge fund manager, he charged clients 25% of their profits. But he was so confident of his methods that he agreed to pay 25% of any losses—an offer he never had to make good on. Then managing about $10 million, Blake made 30 or 40 trades in a fund a year, typically betting everything on each trade and holding his position for no more than two or three days.

As Blake continued to rack up stunning results, others began to copy his strategies. Though the small but growing network of market timers was largely overlooked by the press, Fidelity concluded they were getting out of hand. In 1989 the fund giant took a step to make rapid trading unattractive: It imposed—and enforced—a hefty redemption fee on short-term trades. Blake proposed to a Fidelity official that he rotate into different funds. But the company's attitude had changed. "I don't really think we want your business," the Fidelity executive told him.

The Fidelity crackdown may have pushed Blake out of the Boston-based fund giant, but it didn't stop him—or others—from timing other funds. By then a dozen fund companies allowed market timing—unofficially at least—and word would quickly circulate in the timing community about where they were welcome. "There were probably 50 to 100 people like myself who flowed to whatever organization would allow them to switch—until it got somebody's attention," says Blake.

Blake figured out ways to trade gold funds profitably and employed strategies involving international funds, which became the favorite playground for fund timers. Overseas funds allowed traders a simple but profitable time-zone arbitrage. The price (or net asset value, as it's known in the business) of an international fund was set at 4 p.m. Eastern Time and was based on the closing prices of stocks in overseas markets. But by the time the NAV was set, the overseas markets had been shut down for as much as 14 hours. On days when the U.S. market was soaring, timers loaded up on international funds, betting that the overseas markets would climb when they reopened in a few hours. Usually that's what happened.

Given that Blake was engaged in a strategy that the fund industry publicly frowned on, you'd think he'd want to keep his success under wraps. But he was proud of his record—and wanted people to know about it. "We kept expecting to see [market timing] on the front page of the investing section of the Wall Street Journal," Blake says now. "We had discussions, a small group of us who were doing this, about whether to keep our mouths as closed as possible. We were so successful that there was a real temptation to tell people." By the early 1990s Blake had succumbed. He gave some interviews and participated, with startling success, in an annual money-management contest whose results were published in Barron's and Investor's Business Daily.

In 1992, Blake was profiled in a book entitled The New Market Wizards. The book soon became must-reading in do-it-yourself trading circles, the Blake chapter studied like an instruction manual. Most of the other chapters were devoted to hedge fund operators slinging around billions in arcane options and derivative strategies. But Gil Blake discussed how he traded mutual funds from his home. "It had an Everyman appeal," Blake says today. After the book came out, Blake received hundreds of letters and phone calls. A stranger sent him a check for $100,000, begging him to manage his money. Blake refused. "A couple of females even sent me their pictures," he recalls.

Eddie Stern's Passion

"Everything you see is owned by Hartz," declares a spokesman for the Stern family. We are in the New Jersey Meadowlands, across the river from Manhattan, on a driving tour through the Sterns' domain. In every direction are warehouses and outlet stores, office complexes and strip shopping centers.

Today the Stern family is one of the largest private owners of commercial property in America, with 38 million square feet of space in 200 buildings. Though most of their holdings are industrial sites, the Sterns also own ten million square feet of office space, a million square feet of retail, five hotels, and an elegant high-rise in Manhattan, where Leonard Stern, the family patriarch, keeps his office.

The family fortune was built on birdseed. Hartz Mountain Industries dates back to 1926, when Max Stern arrived in the U.S. from Germany with 5,000 canaries, payment of a debt from the old country. Max launched the pet-supply business, and by the early 1960s son Leonard had taken over. Smart, intense, and aggressive, Leonard built Hartz into the dominant force in the industry. The company's hard-charging ways generated a nasty antitrust suit by competitor A.H. Robins in 1978 (Hartz settled by paying $42.5 million) and a federal grand jury investigation—also settled, when the company pled guilty to perjury and obstruction of justice and paid a $20,000 fine. Stern himself was never charged.

Leonard made the family's first big move into real estate with the purchase of a 750-acre tract that included a Meadowlands pig farm. Another 1,100 acres followed, all developed with a shrewd eye and exquisite timing. The family fortune is estimated at $3 billion.

Now 66, Leonard envisioned setting up his three children in separate realms of the Hartz empire. One arm was publishing, where Leonard had assembled a small chain of alternative weeklies, including the Village Voice, prompting speculation that the business was intended as the domain of daughter Andrea. But Andrea became an accomplished art photographer instead, and Leonard unloaded his print holdings in 1999.

The Hartz pet-supply business was sold too, in 2000, for more than $300 million, with the aim of focusing the family interests on the passions of Leonard's two sons. The eldest, 41-year-old Emanuel, known as Manny, is now president of the real estate operation. A separate investment division became Eddie's province.

Edward Julius Stern—who declined to be interviewed for this story—had once considered a different life. A 1987 graduate of Haverford College, he studied art history in Italy, where he dreamed of earning a doctorate. Instead he returned to New York and joined Spy magazine, a short-lived satiric monthly. After marrying a pediatrician, he entered the family pet-supply business and became its president during the 1990s.

Eddie's real business passion, though, was running money. Most billionaire families hire others to invest their wealth. Not the Sterns. In real estate they prided themselves on designing, building, and managing their properties in-house. They approached money management the same way. Says one Stern business associate: "They wanted it in-house because they think they're the best investors they know."

Eddie began investing money on the side in the early 1990s while working at Hartz, forming a partnership with his brother-in-law, Robert Simpson, which they called Simpson-Stern. Simpson was a market timer, and Stern was drawn to the strategy. He had read about Gil Blake in The New Market Wizards and had tried to invest with him. But Blake wasn't taking on new clients, so Simpson-Stern turned to another, far more flamboyant fund timer named Norm Zadeh.

Today, at age 53, Norm Zadeh is out of the investment business. From a Beverly Hills mansion, he runs a soft-core-porn magazine and website called Perfect 10, devoted to displaying the virtues of purportedly silicone-free women. But before turning into a Hugh Hefner wannabe, Zadeh ran the U.S. Investing Championship, the contest whose results first garnered attention for Gil Blake's strategies. Zadeh, in fact, was a crack number cruncher who'd earned a Ph.D. in applied math at Berkeley, taught at Stanford, and played high-stakes backgammon and poker. In the 1990s, Zadeh started his own hedge fund, part of which was devoted to market-timing strategies.

Unable to get into Blake's fund, Simpson-Stern invested a few hundred thousand dollars in Zadeh's. Over the next seven years Zadeh built his client portfolio to more than $100 million, racking up annual returns of more than 25%. "These systems can make 80% a year," Zadeh explains. "It's relatively easy." Simpson and Stern thought so too. They started timing mutual funds on their own and eventually pulled out of Zadeh's fund.

By the late 1990s hundreds of millions of dollars were rushing into fund timing. "The timing wave had a parabolic growth," says Blake. And just as Fidelity had done a decade before, many fund companies started to push back, imposing redemption fees and kicking out market timers. "It got harder and harder to find places to trade," says Blake.

Blake scaled back and moved his remaining accounts to Rydex, a small firm that openly welcomed rapid trading. Zadeh got out of the business. He marveled at how his old customer Simpson-Stern seemed to be expanding as others were being shut down. "I was trading at Smith Barney," Zadeh recalls, "and I got kicked out and they didn't."

The Game Gets Dirty
Until then, it had been a kind of game. Market timers played cat-and-mouse with mutual funds, relying on their own cleverness—and the apathy of the fund industry—to stay in business. When they got tossed from one fund complex, they moved to another. Like card counters, they weren't breaking the law. If other shareholders were hurt by their actions, well, that was hardly their responsibility.

After the late 1990s crackdown, though, the tenor of the business changed. To keep making in-and-out trades, market timers had to be willing to deal with sleazy middlemen and cut secret deals with fund complexes that were publicly clamping down on fund timing. These market timers might still argue that they weren't violating the law, but that argument was increasingly strained—and in any case they could hardly deny the stench that now emanated from the whole affair.

Here's how it worked. Market-timing hedge funds—as well as brokers and other middlemen—negotiated secret "capacity" arrangements in which they gained the right to run a predetermined amount of money in and out of a fund and were exempted from short-term redemption fees. In return, the market timer handed over a second predetermined amount to the fund company—"sticky assets," which sat quietly and generated extra management fees for the fund complex. Often the sticky assets were placed in low-risk money-market or government bond funds. But sometimes they'd end up in a hedge fund run by the fund managers, generating much juicier fees for both the portfolio managers and their firm.

Stern made his first such unsavory arrangements through a broker named Alan Lederfiend, whose firm negotiated capacity deals. After a falling out with Simpson, Stern had started his own fund and become a client of Lederfiend's. In mid-1998, according to investigators, Lederfiend struck a deal with PBHG, the momentum-oriented fund complex run by co-founders Gary Pilgrim and Harold Baxter. PBHG was precisely the kind of fund company that was cracking down on market timing while secretly granting unseemly exceptions. One exception was for Appalachian Trails, a hedge fund in which—astonishingly—Pilgrim and his wife owned 50%. (Ultimately Pilgrim pocketed $3.9 million from the deal, even as his fund dropped some 60%. See The House Always Wins.) A second exception was made for clients of Lederfiend, a close Baxter friend.

Through Lederfiend, Stern made a deposit of $4 million in a private investment fund run by Harold Baxter's daughter. He was then granted virtually unlimited capacity in a small-cap PBHG technology fund. (A Stern spokesman denies there was any quid pro quo.) Applying the basic Gil Blake strategy, Stern bought into the fund on days the market was moving up and dumped it when the market was going down. By the end of the year he'd earned 18%. That was nice, of course, but he was just getting started.

Peeking At Portfolios

Eddie Stern had big plans for his new market-timing hedge fund—called Canary, in homage to his family's history. So in 1999, as he was winding down his tenure as president of the pet-supply business and preparing to immerse himself in the world of fund timing, he made two key hires.

One recruit was a trading technician named Andy Goodwin, a baby-faced Harvard graduate with a Columbia MBA. The second was Jim Nesfield, a rough-and-tumble Bronx-born student of Wall Street's entrails. Goodwin would help Stern pioneer new, sophisticated fund-timing systems; Nesfield would become Stern's point man in the endless search for more capacity. Both would help lead Stern into uncharted territory.

Just 30 when he signed on with Stern, Andrew St. John Goodwin seemingly had the perfect resume for his new job. Two years earlier, he had published Trading Secrets of the Inner Circle. The book's preface describes him as a "master trader" who had "racked up double-digit annual returns" and never had a losing month.

In fact, Goodwin had taken some liberties with his past. For one, he had Anglicized his name, changing it from Andrew Goodstein. For another, he had spent little time running money for his own investors—at least on a major scale; Goodwin's main trading experience had come during three brief stints at high-profile hedge funds.

Not long after joining Stern, Goodwin helped his new boss develop the next wrinkle in market timing: shorting mutual funds—something that had long been thought impossible. But it wasn't impossible. It just required a willingness to break the rules.

Why did Stern want to short funds? Because when the bear market began after 1999, the old Gil Blake momentum strategy no longer made sense. Blake's early method worked best in an up market; if Stern wanted to make the kinds of outsized returns that market timers coveted, he needed to be able to profit when funds went down as well.

Goodwin's notion was to create a financial instrument, which Stern could then short, that replicated all the stocks in a fund's portfolio. But that was possible only if Goodwin and Stern knew what was in the portfolio. The SEC requires fund companies to disclose portfolio holdings twice a year—but that information is usually months old, useless to those hoping to exploit it.

That didn't stop Stern. Starting with PBHG, he persuaded managers at several fund groups—including Strong, Pimco, Invesco, and Alliance—to regularly provide lists of their funds' portfolio holdings. With that information Stern and Goodwin created a synthetic derivative that closely replicated the stocks held by the fund. By 2001, Canary was profiting when the market was streaking downward as well as when it was steaming ahead.

The second issue was timing capacity. As his fund got bigger, Stern needed to cut more and more secret deals with more and more fund companies involving ever larger sums of money. Finding all that capacity became Jim Nesfield's responsibility.

Nesfield was a veteran of Wall Street's underground—literally: He'd started out four stories below street level in Paine Webber's huge municipal bond vault. After dropping out of seminary—and then college—he moved through a dozen jobs on Wall Street. He came away from this experience with an intimate knowledge of how investments are cleared and processed—and a powerful sense that "everyone had an angle."

When Stern found him in August 1999, Nesfield had relocated to Nag's Head, N.C., and was working on a fishing boat to help pay the bills. Now 45, Nesfield lives in a ramshackle $35,000 house, hours from a major city, with his second wife and four of his seven children.

After stumbling across Nesfield's resume on the Internet, Goodwin invited him to New York to talk about signing on with the Stern family's new hedge fund. Nesfield hopped into his battered Plymouth and drove to Canary's offices in Secaucus, N.J. "We're telling you about this new stuff, and you've got to keep it secret," Stern and Goodwin told him.

Nesfield signed on as a "capacity consultant" for $50 an hour. He immediately returned home and began looking through listings of all the companies that touched a mutual fund trade. Nesfield was searching for ways into the system that would allow Canary to tap into funds and market-time at will. "I knew what they wanted," he says. "They wanted carte blanche. And they wanted a system that could be easily manipulated to cover their tracks."

He also knew how to pull it off. Mutual fund orders are supposed to be entered by the close of trading at 4 p.m. Eastern Time, but don't actually make their way through the processing pipeline until many hours later. Hundreds of entities play a part in that process, including brokerage firms, processing agents, and third-party administrators that manage back-office duties for corporate 401(k) plans and other institutional customers. Each provides an access point.

Using a battered laptop and a dial-up modem from an upstairs bedroom, with chickens in the backyard and his home-schooled kids downstairs, Nesfield launched a massive search for funds that would welcome Stern's money—and processing firms that would play his game. "I ran a spam campaign on the goddamn fund companies," he says. "It was like I was selling Viagra." The pitch was worded gently. "It's like if you're picking up a woman at a bar. You talk in generalities. You don't come out and say, 'I want to get in your pants.' " When Nesfield found a prospect, he would hand it over to Stern. "All I did," he says now, "is set Eddie up for the kill." He adds, "Eddie wasn't telling me all of the secrets."

'One-Stop Shopping'
There was one final wrinkle. It was late trading—and it was flatly illegal. Late trading didn't just improve the odds for timers, it virtually guaranteed them. Late-trading ability allowed Canary (and others) to purchase fund shares at the current day's price after the 4 p.m. cutoff time. That meant Stern could observe post-closing news developments that were likely to move the markets the next day (a big earnings surprise, for example), then place a trade based on that information. Spitzer likens it to "betting on a horse race after the horses have crossed the finish line."

According to investigators, Canary's first such arrangement was formally inked on Feb. 29, 2000, with Kaplan & Co. Securities, a tiny firm in Boca Raton, Fla. Under the terms of a seven-page contract, Canary would provide Kaplan with a preliminary list of mutual fund trades by 2:30 p.m. Eastern Time. But "final instructions" for trades could be sent as late as 4:30, a half-hour after the market closed—and late enough to exploit the many earnings reports released right after the closing bell. In return, Kaplan got a small percentage of all the money it handled for Canary. (Kaplan's founder insists the firm has done nothing wrong.)

This arrangement was soon followed by a second, far more important deal, with a firm called Security Trust Co. Though unknown to the general public, Phoenix-based Security Trust was a market timer's dream, providing—as Spitzer later put it—"one-stop shopping" for both market timing and late trading. Through its electronic-trading platform, Security Trust had access to more than 200 fund families. As an administrator for 2,300 retirement plans with $12 billion in assets, it handled enough trading volume to obscure Canary's frenetic activity. And because it also processed fund trades, it could sneak orders in late—very late.

In return for a hefty 4% of Canary's profits, STC put all its resources at Eddie Stern's disposal. Between May 2000 and July 2003, government regulators now charge, Security Trust orchestrated trading by Canary in 397 mutual funds. According to the government, 99% of the trades were submitted to STC after the 4 p.m. market close; 82% were submitted between 6 p.m. and 9 p.m.—and still got the 4 p.m. price!

What's more, STC actively conspired with Stern to hide his trades. According to the government, STC set up more than 100 separate Canary accounts. It told the mutual funds that Canary's trades were really being submitted by retirement-account customers. And it concealed Canary's activities by "piggybacking" its trades—bundling them with those of legitimate customers. According to an SEC complaint, STC made $5.8 million on its unholy alliance with Canary. And Eddie Stern? His fund's profits through STC trades would total a stunning $85 million.

In 1999, a year in which the S&P 500 rose 20%, Canary was up more than 110%. The following year, with late trading and short-selling in its arsenal, Canary was up nearly 50%, even though the market was down. With that track record, Stern had begun accepting money from wealthy outside investors. By January 2001, Canary's $184 million under management included $40 million from outsiders. Stern was charging a management fee of 1.5% of the fund's assets, plus 25% of all profits.

And he wasn't close to being done.

The Virus Spreads

Why was the mutual fund industry so willing to risk its reputation by getting in the muck with the market timers? The answer is that by the end of the bull market, fund companies were under enormous pressure. Their management fees depended on their ability to gather assets and make those assets grow. But as the market dropped, so did assets under management, both because of performance declines and because investors were bailing out. And that made the firms desperate to attract assets any way they could.

Eddie Stern took full advantage. Take, for instance, the deal Canary cut in November 2001 with Pimco Advisors, the company best known for its fixed-income funds, managed by "bond king" Bill Gross. That deal was negotiated for Stern by Brean Murray broker Ryan Goldberg, Pimco documents released by regulators show. Pimco was to give Stern $100 million of timing capacity in three of its funds—and the right to make a staggering 48 in-and-out trades a year—in exchange for $25 million in sticky assets. Investigators say the sticky assets went directly into a fund managed by Kenneth Corba, CEO of PEA Capital, an affiliated company that managed Pimco's equity funds. Corba had negotiated the deal with Goldberg. (Corba declined comment.)

In January 2002 a Pimco executive sent Canary's brokers a detailed list, just two weeks old, of the holdings for each of the targeted funds, including one called the Innovation fund. Two months later, after the portfolio manager's objections forced Canary out of that fund, Pimco executives met with Stern and his Brean Murray brokers again. Stern wanted extra capacity at other Pimco funds to replace what he'd lost—and he was willing to sink millions into Pimco-managed hedge funds to get it. He offered to pony up $2 million immediately. "Our ultimate allocation," he wrote after the meeting, "could go as high as $8 million." Then came the inevitable caveat: "We would, however, like to see a little give on the fund-trading side. We were pretty bummed about losing access to [the Innovation fund]."

Stern's request was granted. Immediately Canary began trading: $32 million in, $32 million out, usually in just a few days. Pimco executives watched with growing dismay. In May 2002, Corba wrote Stern's brokers at Brean Murray, "The pattern that is most disturbing to me is that you only seem to be interested in being in our funds for a day or two at a time—perhaps the most opportunistic but extreme sort of market timing that I have ever seen."

Yet Pimco not only allowed the trading to continue but also gave Canary more capacity. In the space of 18 months Canary made more than 200 trades at Pimco, averaging $20 million a pop. Total trading volume involved: more than $4 billion.

And where were Pimco's timing police while all this was going on? They were busy rooting out most of the small market timers who were playing the old cat-and-mouse games. But a Pimco timing cop would later tell investigators that he had been "directed to not—again, not—apply our market-timer procedures to those accounts." (Pimco declined to comment.)

Canary orchestrated a similar arrangement at Alliance Capital Management, where Stern was ultimately granted as much as $110 million in timing privileges. Under the deal, Stern invested $1 in the firm's hedge funds for every $2 of timing capacity. On several occasions, Alliance also gave Canary confidential portfolio information—once passing on the holdings in five of its funds as of the previous day.

At Janus Capital, Canary was permitted to market-time the Mercury fund. In early 2003, when Stern sought additional capacity, a Janus employee complained to Janus International CEO Richard Garland. "We need to keep our funds clean," he wrote. "Do you agree?"

Garland did not. "I have no interest in building a business around market timers," he replied, "but at the same time I do not want to turn away $10 to $20 million! How big is the [Canary] deal ...?" Told that it could amount to as much as $50 million in timing money, Garland gave the go-ahead.

At Invesco, Stern poured tens of millions in timing money into the firm's funds. In one fund alone, Invesco Dynamics, Stern made 141 exchanges, totaling $10.4 billion—twice the size of the fund—in a two-year span. According to Spitzer's office, Canary made $50 million just timing Dynamics during this period, even as long-term investors were getting crushed.

In May 2002, according to regulators, Invesco CEO Raymond Cunningham had personally negotiated an arrangement giving Canary an additional $100 million of capacity in offshore mutual funds run by an Invesco affiliate. Invesco received 0.1% of all monies transferred offshore. The first trades in July immediately generated $60,000 in fees for Invesco. (Cunningham and Invesco declined comment.)

In all, Eddie Stern had market-timing agreements with 30 mutual fund companies. And he had plenty of company. There was Samaritan Asset Management Services, run by an evangelical Christian named Edward T. Owens, who used his timing (and, regulators say, late-trading) profits to fund religious ministries. There was New York's $3.7 billion Millennium Partners, run by Israel Englander; Chicago-based Ritchie Capital, run by A.R. Thane Ritchie, whose family bankrolled private efforts to overthrow Afghanistan's Taliban; a fund run by Monroe Trout, yet another of the "New Market Wizards"—and dozens more.

Indeed, at Alliance—a firm that held more than $600 million in "approved" timing money, employed a "market-timing supervisor," and generated a "top ten timers" list—Canary didn't even rank as the biggest rapid trader. That "honor" went to a Las Vegas attorney named Daniel Calugar, who topped out at $220 million in timing capacity. Calugar, who has also been charged with late trading by the SEC, operated under an agreement in which he invested in Alliance hedge funds in proportion to the timing capacity he'd been granted. The hedge funds that got the sticky assets were, of course, run by the very same portfolio managers whose mutual funds Calugar was timing. According to later SEC calculations, Calugar pocketed $64 million in profits from timing Alliance mutual funds between 2001 and 2003. Calugar was also one of nine "approved" timers at Fleet Boston's Columbia fund group—which allowed him to time its Young Investor fund, marketed for participation by children, to provide the "investment that's also an education."

And so it went. By allowing virtually unbridled timing in 11 of its funds—internally classified as "unrestricted funds"—Boston's MFS drew an estimated $2 billion in timing cash. Janus had ten agreements with timers. Bank One and Franklin Templeton both allowed their funds to be timed.

Invesco—described as a "timer-friendly complex" by the firm's own chief compliance officer—didn't merely accommodate fund timers but solicited them under what was known internally as the "special situations" program. "If done correctly," noted Invesco's chief timing cop, Michael Legoski, in an October 2001 memo, "this kind of business can be very profitable."

All that continued despite constant complaints from Invesco portfolio managers, who were boiling with frustration. Market timing "is killing the legitimate shareholders," complained one. In an early 2003 e-mail to Invesco's top executives, Dynamics fund manager Timothy Miller wrote, "I sent a message yesterday about the timers (it was Canary), and sure enough they came in two days ago in Dynamics with $180 million, and left yesterday.... They are day-trading our funds, and in my case I know they are costing our legitimate shareholders significant performance. I had to buy into a strong early rally yesterday, and know I'm negative cash this morning because of these bastards, and I have to sell into a weak market. This is not good business for us, and they need to go."

Indeed, after the scandal broke, the SEC surveyed the 88 largest fund companies and discovered, stunningly, that half admitted to allowing market timing—and 25% allowed late trading.

Just as with other corporate scandals, banks helped enable the illegalities—and then helped cover them up. Some lenders allowed timing hedge funds to open accounts in their name. They also arranged financing, knowing full well what the money was being used for.

Investigators say CIBC was among the biggest lenders to market timers, arranging more than $1 billion in financing. And earlier this year Spitzer and the SEC filed criminal and civil fraud charges, respectively, against banker Paul Flynn, a former CIBC managing director. Both agencies allege Flynn knew that two of his clients, Canary and Samaritan, were engaged in illegal late trading through Security Trust. As evidence, they cite an astounding memo Flynn wrote to colleagues after a 2001 "due diligence" trip to STC's offices in Phoenix. Flynn noted "the benefits this proprietary platform brings to our Mutual Fund Market Timing clients," including the ability to get 4 p.m. prices on trades submitted as late as midnight. (CIBC declined to comment.)

Clearly, by 2001 everyone connected with the fund industry had to know how crooked the business had become. Articles were written in trade publications, in which fund companies discussed how they were working with market timers—supposedly to better control them. Timers sought capacity openly on Internet message boards. Even the clean companies knew about the market timing, since they were being solicited along with everyone else.

Everyone seemed to know, that is, except the buy-and-hold investors in mutual funds, and the SEC, which appeared to be clueless. "I don't think there's anyone at the agency who doesn't wish the agency had been more attuned to this problem before it came to light," says chagrined SEC enforcement director Steven Cutler.

Late Trading Made Easy

There's one more Canary relationship worth dwelling on, perhaps the biggest and dirtiest of them all: Bank of America. BofA would take the "one-stop shopping" concept even further than Security Trust.

The BofA connection was forged in April 2001, when Ted Sihpol, a broker in the private-client services department, cold-called Eddie Stern. Would he be interested in trading mutual funds through the bank? "It was," says one person familiar with the case, "like a fly cold-calling a spider."

The bank offered up its own Nations Funds for timing. It provided a credit line (ultimately $300 million) for Canary. And it provided derivative facilities—and a peek at portfolio holdings—so that Stern could short its funds. "Bank of America was lending us the money that we used to market-time their funds," marvels an ex-Canary employee.

Bank of America offered Stern something else: his own electronic trading terminal so that Canary could late-trade mutual funds. Using this system, Canary could enter mutual fund trades—and get that day's prices—as late as 6:30 p.m. And not just the Nations Funds. Stern could late-trade all the other fund families in the bank's clearing system—hundreds in all.

Even before the terminal was installed, Sihpol and his colleagues were helping Stern engage in late trading, SEC and New York regulators charge. They say Stern would submit "proposed" fund trades by fax before 4 p.m. so that Sihpol could time-stamp them before the deadline. Then, after 4 p.m., Canary traders would phone in final instructions. If Canary canceled any "orders," the brokers discarded the trading ticket. Those that were confirmed were submitted for processing as though they'd been properly placed.

The trading platform, installed in mid-2001, made late trading even easier. With its own terminal, Canary could bypass the brokers altogether, submitting late trades almost invisibly, as though it was simply an administrative arm of the bank.

In January 2002, Charles Bryceland, Sihpol's boss, e-mailed the bank's head of asset management, offering "accolades" to all involved in the Canary relationship: to the Nations Funds executive for "giving access ... for market-timing activities," to the private lending department, and to Sihpol. "It is always nice to enter a new year with a success like this," he wrote. "Thanks to all team members who have contributed to this profitable relationship."

Eddie Stern's Boiler Room
At the end of 2001, a year in which the S&P 500 fell by 13%, Canary returned 28.5% to its investors, even after management fees. Stern's results drew money like a magnet. During 2002, Canary's assets mushroomed from $400 million to $730 million—including $340 million from outside investors. With his ability to borrow from Bank of America and CIBC, Stern had around $2 billion he could time.

Which meant, of course, that Stern was more desperate than ever for timing capacity. He—and other timers—branched out into timing variable annuities, an insurance product with an investing component. Some annuity companies later claimed to know nothing about the timing activity—even though some hedge fund employees underwent physical exams before the insurance companies would sell them annuities they could time.

Stern's trading volume was enormous. In addition to the approved timing capacity, Stern often tried to trade "under the wire," using a hidden channel like Security Trust or Bank of America, hoping to go undetected. "A fund would allow us to get in and out five or six times," says a former Canary hand, "and we'd do it ten times. Canary always went for a few more."

How much did Leonard Stern know? It's impossible to say, but as with everything related to the family business, he was a looming presence at Canary. One former employee recalls him sticking his head into a conference room where Eddie was running a meeting. "My sons," he gushed proudly. "They're making me so much money!"

By 2002 there was little effort inside Canary's office to hide what was going on. The Bank of America terminal was out in the open. Stern responded personally to an Internet timing solicitation, leaving his initials and phone number. And the pace of the office was odd by Wall Street standards. As a former Canary employee recalls, "I had a brokerage background, where I always saw all the excitement going on before four o'clock to get the trades in before the market closed. At Canary it was just the opposite. Nothing was done until after-hours."

One Canary employee remembers the frenzied activity after the market closed on Oct. 16, 2002. The Dow had plunged 219 points that day, and the Nasdaq fell by 50. But after the close, IBM announced a stunning earnings surprise, beating expectations by 3 cents a share and signaling a new direction for the market. Canary's traders jumped in, using their late-trading access to buy funds at the 4 p.m. closing price that reflected the 3% drop that day in the market. Sure enough, shares leaped the next day—the Dow by 238 points, the Nasdaq by almost 40. Canary made a killing.

As 2002 came to a close, it was clear that Canary was going to have another good year. That December, Eddie Stern threw a year-end party for his employees at the Tribeca Grand, a chic new Manhattan hotel built by the Stern family. Before the party began, Stern led everyone to the hotel's private theater for a screening Eddie thought his staff would appreciate. The lights darkened and on came a movie about a young man who immerses himself in the dark, sleazy underbelly of Wall Street. They watched Boiler Room.

The Whistleblower

Eddie Stern had a request for his new employee, Noreen Harrington: He wanted her to help persuade Goldman Sachs to let him time its mutual funds. The white-shoe firm had already turned Stern down, but Harrington had worked at Goldman for 11 years, and Stern thought that connection might help change the firm's mind. It didn't. The Goldman response was blunt: Why would the firm violate its prospectus and let someone make rapid trades? To do so would be illegal.

Harrington, 46, was a Wall Street veteran, though she'd never had much to do with mutual funds. After her Goldman stint, where she'd risen to managing director, she'd served as co-head of global fixed-income investments for Barclay's Capital. The Sterns had hired her in April 2001 to help diversify the family money that wasn't in Canary.

The Goldman request had come before she fully understood how Eddie Stern made his money. Gradually, she began to realize that something sleazy was going on. She'd seen Canary traders putting mutual fund orders through at 8 p.m. "There's big news," she recalls now, "and then there's a trade."

Finally, Harrington asked directly: "How can this be okay?" Stern said he had a legal opinion that everything he was doing was fine. Besides, he added, "If the regulators ever look at this, they'll go after the mutual funds."

By the summer of 2002, Harrington had left the Sterns' employ, unhappy with the atmosphere but not intending to blow the whistle. In fact, she even kept some of her own money in Canary. Nearly a year later she heard her sister complaining about how much money she'd lost in mutual funds and how worried she was that she'd never be able to retire. "I didn't think about this from the bottom up," says Harrington, "until then."

Impressed with Spitzer's success in cracking down on Wall Street analysts, she nervously placed a call to his office one morning and left an anonymous message: "I think you should investigate mutual funds because people are doing way too many trades and doing late trading after the close of business. There are violations of security laws by the hedge funds and mutual funds."

Even before Harrington's call, Spitzer's newly hired assistant attorney general David Brown had convinced his boss that he should start poking around the fund business. Fresh from three years at Goldman Sachs, Brown had concluded that the industry was not as clean as it appeared. In May 2003, Harrington came to Spitzer's office and told his investigators what she knew. Brown was off and running.

By then, Stern was winding down. In February, Invesco had finally cracked down, cutting back Canary's timing capacity, restricting the funds it could time, and reducing the allowable number of trades. Other fund companies also began imposing new restrictions. After four months Canary had made just 1.53% in 2003, lagging the market for the first time. On May 2, Stern advised his outside investors that he was returning their money. "Strategies that had worked well for a number of years have not worked recently," Stern wrote in his letter to investors. He concluded: "We hope that you considered the ride to be a good one."

A subpoena arrived two months later. Stern quickly liquidated mutual fund holdings and laid off most of Canary's staff. He retained Gary Naftalis, a top New York white-collar crime attorney, and within 60 days a deal was struck: Stern would pay $40 million in fines and restitution of improper profits and accept certain restrictions on his investing activities. But he wouldn't have to serve a day in jail. In return, he would become the star witness in a scandal whose scope has surprised even Spitzer's investigators.

Stern spent much of his summer talking to investigators. Then, on Sept. 3, the AG dropped his bombshell: State Investigation Reveals Mutual Fund Fraud, read Spitzer's press release. In addition to unveiling the Stern settlement, Spitzer released dozens of damning documents from Janus, BofA, Bank One, Strong, Security Trust—and Canary. The SEC didn't even learn of Spitzer's investigation until that morning, when enforcement director Cutler discovered that Spitzer had called a press conference. He phoned Spitzer and asked, "What are you doing?"

The SEC, the Justice Department, and numerous state regulators soon joined in what has become a massive investigation. But it is Spitzer who has led the charge. To date, his office (working with the SEC) has negotiated four mammoth settlements totaling more than $1.65 billion.

• Alliance has agreed to pay $250 million in restitution and cut fund-management fees by $350 million over five years. MFS has agreed to pay $225 million and slash fees by $125 million. Bank of America, eager to complete its merger with Fleet Boston/Columbia, agreed to a package for both itself and Fleet totaling $675 million—$515 in cash, plus another $160 million in fee cuts. All the firms have fired executives and agreed to management reforms.

• Spitzer has filed felony criminal charges against Bank of America broker Ted Sihpol and CIBC banker Paul Flynn, both of whom maintain their innocence. He has charged three top executives at Security Trust; one has pled guilty. Federal regulators have closed the firm. Spitzer has also won guilty pleas from a trader at Millennium Partners, who admitted to engaging in late trading, as well as a vice chairman at Fred Alger management, who confessed to destroying evidence concerning timing deals.

• At PBHG, co-founders Gary Pilgrim and Harold Baxter have left the firm and been charged with fraud by both Spitzer and SEC. New Jersey authorities have filed civil fraud charges against Pimco.

• Massachusetts regulators and the SEC have charged Putnam and two of its portfolio managers with fraud in connection with market timing by Putnam employees. The firm later disclosed that at least 40 Putnam employees had been timing the firm's funds. The firm replaced its CEO and fired six portfolio managers. Massachusetts regulators have also filed fraud charges against Franklin Templeton for permitting market timing by Daniel Calugar, and against Prudential and a group of market-timing brokers in its Boston office. Prudential says it has fired more than a dozen employees. Bear Stearns, Citigroup, Merrill Lynch, and UBS Warburg have also fired brokers in connection with market-timing issues.

And there's more to come. Invesco and its CEO, Raymond Cunningham, are facing civil fraud charges from both Spitzer and the SEC. (Invesco's parent firm says it is seeking to settle the charges against the firm.) Bank One says it is expecting enforcement action by Spitzer for allowing timing in its funds. Janus, which has volunteered to pay $31.5 million in restitution for allowing a dozen timing arrangements, says it is seeking a settlement with the SEC. Strong Capital founder Richard Strong, who stepped down after Spitzer's office alleged that he market-timed his company's funds, awaits charges from the New York AG.

Although Eddie Stern was deeply involved in many of the illegal activities he has described to prosecutors, neither Brown nor Spitzer makes any apologies for his light treatment. "The truth is that we picked the absolute best person to bring in as our cooperator," says Brown. "He's given us 20 or 30 names of mutual funds, 20 or 30 names of hedge funds, ten late-trading vehicles." Adds Spitzer: "We realized having his cooperation would permit us to lay bare an entire array of relationships that were improper. He did get a good deal. People who are there early get good deals. We did the right thing."

Earlier this year Spitzer quietly settled his suit against the Hartz heir and dismissed the fraud complaint. The agreement bars Stern from managing outsiders' money for ten years, though he remains free to invest his family's wealth. In fact, he can even still own mutual funds. But he has to hold them for at least a year.